A Pandora’s Gift Box
Thinking about making a charitable contribution of a conservation easement for tax purposes? Beware of opening a Pandora’s Box with the Internal Revenue Service. The IRS is aware that taxpayers who transfer easements may be improperly claiming charitable contribution deductions under the Internal Revenue Code Section 170.
Under IRC Section 170(h), a taxpayer who makes a qualified conservation contribution is entitled to a charitable contribution deduction for tax purposes. A qualified conservation contribution is considered a donation of a real property interest to a charity exclusively for conservation purposes. The property interest donated is generally known as a “conservation easement” and essentially entitles the taxpayer to a charitable contribution deduction equal to the fair market value (FMV) of the easement. “FMV” is defined as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.”
What’s a Conservation Easement?
The term “conservation easement” is broadly used to include all essentially similar restrictions on land use, which include agricultural preservation easements, scenic easements, open space easements and conservation restrictions; easements used to preserve the façade and surroundings of historic structures are called historic preservation easements. In general, an easement is an interest in real property that transfers use, but not ownership, of a portion of an owner’s property. The Dictionary of Real Estate Appraisal defines a “conservation easement” as a “restriction that limits the future use of a property to preservation, conservation or wildlife habitat.” These easements are recorded, binding agreements between property owners and either a government agency or an approved non-profit organization for the purpose of preserving in perpetuity a property’s character or use.
Burden of Proof
The taxpayer bears the burden of proving they are entitled to any claimed deduction and must substantiate the amount of the deduction with a qualified appraisal that must be submitted with tax returns. Since each tax situation and property is unique, owners or donors should seek professional counsel to clarify legally required or prohibited methodologies and to assist the appraiser in developing a clear knowledge of all of the property’s uses before and after recordation. Those uses must be understood and clearly explained in the appraisal document. Most importantly, the appraisal must comply with all federal requirements and must be able to hold up under the examination and intense scrutiny of the IRS, which critically audits and reviews every case involving a conservation easement. If a conservation easement satisfies the IRC requirements, then the grantor of a conservation easement may receive a charitable income tax deduction. Failure to meet the specific requirements results in disallowing the claimed charitable contribution.
Ideally, FMV of a conservation easement is based on the sales prices of comparable easements. Also known as the direct comparison method, the appraiser compares actual sales of easements directly to the easement being appraised. One distinct disadvantage of this approach is finding comparable real estate with comparable easements. Because there’s no organized market for these easements, it’s very difficult to find comparable real estate for direct comparison. These types of sales are rarely available because they’re typically granted by deed or gift rather than sold. An alternative methodology used to establish FMV is called the “before and after” method. In this method, as the name implies, the “before” value of the property is determined without the conservation easement and the “after” value is determined with the real estate as encumbered by the easement. The difference is the value of the easement. The IRS suggests that the value of the easement be based on sales of similar easements whenever possible, however the before and after method is generally acceptable if substantial record of market data isn’t available.
Highest and Best Use
Highest and best use is probably the single most important appraisal principal and is fundamental when estimating FMV. In specifically determining the FMV value of a conservation easement, the appraiser must consider the property’s highest and best use before and after. Aside from methodology, the highest and best use analysis is considered the most critical portion of the valuation process in a conservation easement appraisal – in fact, most of the time, unless highest and best use is affected, little or no change in value can be demonstrated from the restriction of a conservation easement.
The highest and best use analysis is an attempt to identify a property’s most productive use. The analysis begins with a discussion of legally permitted uses for the property, primarily taking into consideration the zoning ordinance that determines legally permissible uses for the property, as well as any applicable federal laws (for example, a wetlands designation). Other factors include deed restrictions and adjoining uses. Then, from legally permitted uses, physically possible uses are considered. These uses are determined from examination of location, access and physical characteristics of the site, such as size, topography and layout. From the uses that are legally permissible and physically possible, financial feasibility is examined. The influence of economic conditions, availability of financing and market demand is examined for each potential use. Finally, the maximally productive or highest and best use of the site selects from the financially feasible uses that use producing the highest financial return.
The Treasury regulations require one other appraisal element. If the gift of the easement enhances the value of adjacent property owned by the donor or related parties, the value of the easement is to be reduced by the enhancement. This can occur when a scenic easement is granted that would preclude a future purchaser building near the donor’s property or when the donor would be guaranteed a view of, and access to, a beach.
Sometimes the proposed highest and best use is different from the current use. When this is the case, the taxpayer must demonstrate closeness in time and reasonable probably of the proposed use. For example, Dietrick Group, LLC appraised a ±115-acre farm located in one of the northern municipalities of Northampton County, Pa. The land was improved with a farmhouse and miscellaneous outbuildings on the primary parcel on the north side of a road and vacant low lying flood prone acreage on the minority parcel on the south side of this roadway. None of the buildings were occupied as of the date of inspection.
Although the subject was considered a functional working farm, regulatory, governmental and municipal entitlements were approved and recorded for a residential subdivision. At the time of the appraisal, the farm was under agreement of sale to buyers who planned to subdivide the farmhouse and outbuildings on 20 acres and convey the development rights of the residual 95 acres to the County. The sales comparison approach was employed using approved lot sales by builders for the ‘before’ valuation and farmland acreage for the ‘after’ valuation. The before value rendered 35 residential building lots; the after valuation was equal to 95 acres of good soil/farmland.
Based on the highest and best use of the subject’s acreage for residential development and with consideration to the influences that affected value, valuation concluded a before value of $2.625 million. Analysis assuming the land encumbered by the easement was performed by comparing easement restrictions to existing zoning regulations and other controls, evaluating the severely limited development potential and concluding continuation of farming as highest and best use in the ‘after’ valuation. The loss in value due to the conservation easement was therefore estimated at $1.675 million. As such, we were able to successfully demonstrate clear, substantial unambiguous difference in FMV between the before and after conditions.
The IRS will, in appropriate cases, disallow charitable deductions for conservation easements and impose penalties and excise taxes. When contemplating the donation of a conservation easement of any type, the appraisal methodology is key to the deduction being allowed by the IRS, and ultimately by the courts. Professionals involved in these transactions should review recent court cases for situations similar to any donation under consideration. If the before valuation contemplates a development plan, the donor and appraiser must be ready to support the physical and economic feasibility of the plan. Keep in mind that a rule of thumb is that for every income tax court case, there are at least 100 income tax audits. Given the number of tax cases on the deductibility of easements in the last few years, this indicates a high level of scrutiny of these donations. Donors and their professional advisors should be prepared. In conclusion, a charitable contribution for a conservation easement isn’t deductible unless properly substantiated in accordance with the IRC and applicable regulations.
Choosing an Appraiser – What to consider
The appraisal is the linchpin of IRS’s decision to accept or reject the legitimacy of the easement. Therefore, equally important as the methodology used to value the easement is the choice of appraiser. The appraiser selected should be qualified to make specific judgments, not only as to value but also must understand the effects of the conservation easement on property values to make those decisions properly. In the selection process, the appraiser’s education and licensing are paramount. The two basic licenses are Certified Residential Real Property Appraiser and Certified General Real Property Appraiser. While the MAI designation is not mandatory, experience with easements for tax purposes is imperative. When evaluating the appraiser’s experience, ask for a resume and a list of two or three references which should include current or previous clients – preferably a client who has made an easement contribution for tax purposes.